MiFID II risks two-tier access to dark liquidity

The latest draft of the European Commission’s revisions to the Markets in Financial Instruments Directive may leave some European investment institutions with diminished access to off-exchange sources of liquidity by formalising discretionary access to broker crossing networks.

The latest draft of the European Commission’s revisions to the Markets in Financial Instruments Directive (MiFID II) may leave some European investment institutions with diminished access to off-exchange sources of liquidity by formalising discretionary access to broker crossing networks (BCNs).

Under MiFID II, BCNs are to be treated as a sub-set of a newly-established category of venue – the organised trading facility (OTF) – which are defined as “internal electronic matching systems operated by an investment firm which execute client orders against other client orders”.

A draft of MiFID II dated 7 October confirms that BCNs will be able to exercise discretion over who can and cannot join their network under the new OTF regime. Operators of BCNs are currently permitted to determine participation, but because they do not fall under any of MiFID’s existing venue categories, the practice has not been officially sanctioned until now.

Some financial institutions – particularly smaller buy-siders in continental Europe – are concerned BCN discretion could lead to exclusive clubs where smaller, peripheral players may be excluded from some attractive liquidity pools.

“Those clients who are members of, for instance, an OTF operated by a large bulge-bracket broker, will enjoy some excellent liquidity, but those excluded from such large OTFs will unfairly miss out,” said one senior industry figure.

Robert Kay, head of analytics at TradingScreen, a provider of execution management systems and TCA services, agreed. He said the ‘consortium dark pool’ model created – but recently dismantled – by Morgan Stanley, UBS and Goldman Sachs, seemed much more likely to dominate under the new rules, alongside established buy-side-to-buy-side providers, such as block trading venue Liquidnet.

“Even though it wasn’t particularly right for them, these banks proved a consortium dark pool could be done. But defining which broker/dealers have enough of the ‘right sort’ of clients may be hard and could act as a basis for squeezing out competition, whether among the ‘bulge bracket’ players or smaller specialist firms,” Kay said.

Under MiFID II, all MTFs and regulated markets will be open to all qualifying members. The only restriction MTFs can apply is for a whole segment of the market – such as being for the buy-side only – and such restrictions must apply in a non-discriminatory way to that segment of the market. Systematic internalisers maintain discretion over membership and, unlike OTFs, can trade against their own proprietary capital. Pre- and post-trade transparency requirements will be “identical” for regulatory markets, MTFs and OTFs.

While a number of commentators have predicted that brokers will attempt to overturn the ban on prop flow in BCNs and OTFs, Kay observes that venue operators will respond to regulation over time. “Europe risks trying to regulate the markets as they are, without allowing for the fact that structures evolve in response to regulation and client demand,” he said. “But these markets will evolve in ways unanticipated by the drafters of the regulations and to the advantage of those best able to exploit any anomalies created by the new rules.”

Anthony Kirby, head of regulatory reform for asset management at Ernst and Young, believes buy-side clients were in need of greater clarification over the differences between BCNs.

“Not all BCNs are the same. Many of the established blue-chip sell-side players either market themselves as unconflicted agency providers or maintain stringent separations of duty between client and proprietary flows,” said Kirby. “There is, however, a greater level of understanding that needs to be reached by the buy-side and regulators about how some other BCNs operate in practice.”

In their hunt for liquidity, Kirby said buy-siders are sometimes reticent to use certain BCNs because they do not want to touch potentially toxic flows.

Kay agreed. “Some clients have voiced concern as to what flow their trade is interacting with in some of these venues,” he said, noting some dealers had responded by offering ‘opt-outs’ within their order routing systems.

For Kirby, buy-side preferences are driven by price or liquidity. “If price is the primary consideration, the benefit of access to an immediate pool of liquidity on tap is not worth the perceived market impact risk,” he said.

But Kay believed without dealer proprietary crossing opportunities, BCN pools could struggle to generate liquidity. He explained that the first iteration of MiFID had tried to impose transparency in ‘off market’ trading done through dealers, by having them register as systematic internalisers (SIs). But a loophole in the regulator’s definition of SIs allowed activity to be crossed with proprietary flow in broker dark pools with no pre-trade transparency requirements.

Kay noted the new OFT regime appeared to be specifically designed to ensure nothing fell outside the net this time around. “Interestingly, the rules are being written to ensure prop trades cannot interact with client orders in these pools,” he said. “That would appear to preclude market-making activity, with the potential result that liquidity in these pools will diminish. In addition it is highly unlikely many single-broker OFTs would have sufficient activity to attract members.”